Credit Spreads

(Bull Put Spreads, Bear Call Spreads)

A credit spread is one in which you sell an option and buy a lower price option, thus generating a net credit to your account. Credit spreads can be bearish or bullish. 

If you're bullish one strategy might be to sell a bull put spread. Assume the stock is at 62. If you think the stock will go higher, you could sell the 60 put, say for 4 and buy the 55 put maybe for 2 1/2.  So you'd take in $400 for sell the 60 strike and you'd have to pay $250 for the 55. Your net credit would be $150, or 1 1/2 points. 

Your margin requirement is $500. That's the difference in the strike prices. That's the absolute most that you can lose on the trade. If your broker requires more than $500 to execute a 5-point spread, fire him!  Your total risk would be $500. No one should require more than that.  Further, if your account is set up to buy options at all, you should be able to open spreads without filling out any other forms or anything else. So you can participate in selling of puts without selling naked puts.

Now, what can happen in this trade? First, if the stock goes higher or at least remains above 60 on expiration date, then both puts will expire worthless and the $150 credit you received is yours to keep. There's nothing to do, no need to call your broker or anything else. They'll just expire and the money stays in your account. 

How much would you have made? You would have made $150 on a $500 investment. What?!!! Yep, your broker requires $500 in your account to collect $150. Do the math --- $150 divided by $500 = 30%.  Thirty percent for about a month's trade. Do you see how selling puts and spreads can be lucrative? Many traders prefer selling puts to writing covered calls. I do both.  

Now I have left out one thing... the commissions. And yes, you will be charged 2 commissions. One for selling the put, and one for buying the other put. So you do have to consider commissions in here. If you were trading just one option, then the commissions might cut in to your profits so much that it's not worth it. But if you were selling 10 then you can see how it gets better. You'd collect $1500 on a $5000 cash requirement in your account. Now commissions don't take such a bite.

Now the down side... Let's say the stock tumbles.... going down, drops below 60, keeps dropping, goes to 50, keeps going, drops all the way to zero. What happens? You close out the trade. The 60 Put that you sold is biting you in the butt, but the 55 is your salvation. Whatever you have to pay to buy back the 60, is offset by the 55 Put, less the 5 point spread. So your total loss can only be 5 points, even if the stock goes to zero.

If this is all new to you, then paper trade some spreads and get the feel for it. If you trade online, the first time you execute a spread, call your broker on the phone and get him to open the trades for you. You want to make sure that you open and close both sides of the trade at the same time. Otherwise, you could get caught "naked".

Example:

Bear Call Spread: